Chapter 6

The Strategic Management Process External Analysis Strategic Choice Strategy Implementation Competitive Advantage Mission Objectives Which Businesses to Enter? Internal Analysis • Vertical Integration Corporate Level Strategy

Logic of Corporate Level Strategy Corporate level strategy should create value: 1) such that the value of the corporate whole increases 2) such that businesses forming the corporate whole are worth more than they would be under independent ownership 3) that equity holders cannot create through portfolio investing • a corporate level strategy should create synergies that are not available in equity markets • vertical integration = value chain economies

What is Vertical Integration? Where your pizza comes from Dairy Farmers (milk) Seed Companies (Alfalfa & Corn) Pizza Chains Leprino Foods (Mozzarella Cheese) Crop Farmers (Alfalfa & Corn) End Consumer Food Distributors

What is Vertical Integration? Backward Vertical Integration Dairy Farmers (milk) Seed Companies (Alfalfa & Corn) Pizza Chains Leprino Foods (Mozzarella Cheese) Crop Farmers (Alfalfa & Corn) End Consumer Food Distributors Forward Vertical Integration

Value Chain Economies The Logic of Value Chain Economies Backward Vertical Integration Dairy Farmers (milk) • the focal firm is able to create synergy with the other firm(s) • cost reduction Leprino Foods (Mozzarella Cheese) • revenue enhancement • the focal firm is able to capture above normal economic returns (avoid perfect competition) Food Distributors Forward Vertical Integration

Competitive Advantage If a vertical integration strategy meets the VRIO criteria… Is it Valuable? Is it Rare? Is it costly to Imitate? Is the firm Organized to exploit it? …it may create competitive advantage.

Value of Vertical Integration Market vs. Integrated Economic Exchange • markets and integrated hierarchies are ‘forms’ in which economic exchange can take place • economic exchange should be conducted in the form that maximizes value for the focal firm • thus, firms assess which form is likely to generate more value Integration makes sense when the focal firm can capture more value than a market exchange provides

Value of Vertical Integration Three Value Considerations Leverage Capabilities Manage Opportunism Exploit Flexibility • firm capabilities may be sources of competitive advantage in other businesses • opportunism may be checked by internalizing (TSI) • internalizing is usually less flexible • flexibility is prized when uncertainty is high • internalizing must be less costly than opportunism • if not, then don’t integrate exchange

Rarity of Vertical Integration Integration vs. Non-Integration • a firm’s integration strategy may be rare because the firm integrates or because the firm does not integrate • thus, the question of rareness does not depend on the number of forms observed • a firm’s integration strategy is rare or common with respect to the value created by the strategy Example: Toyota’s Choice Not to Integrate Suppliers

Imitability of Vertical Integration Form vs. Function • the form, per se, is usually not costly to imitate • the value-producing function of integration may be costly to imitate, if: • the integrated firm possesses resource combinations that are the result of: • historical uniqueness • causal ambiguity • social complexity • small numbers prevent further integration • capital requirements are prohibitive

Imitability of Vertical Integration Modes of Entry • acquisition and internal development are alternative modes of entry into vertical integration • thus, one firm may acquire a supplier while a competitor could imitate that strategy through internal development • in both cases, the boundaries of the firm would encompass the new business • strategic alliances can be viewed as a substitute for vertical integration—without the costs of ownership

Organizing Vertical Integration Functional Structure (U-Form) CEO’s Role Cooperation Accounting Finance Marketing HR Engineering Original Business Original Business Original Business Original Business Original Business Conflict Cooperation New Business New Business New Business New Business New Business Conflict

Organizing Vertical Integration Management Controls What needs to be ‘controlled’ in a vertically integrated firm? • managers’ efforts to achieve the desired value chain economies • cooperation and competition among and between functions • the integration of new businesses into the existing business • time horizon of managers

Organizing Vertical Integration Management Controls Board Committees Budgets • separating strategic and operational budgets • provide oversight and direction to managers • strategic: inputs & outputs • help ensure that strategic direction is maintained • operational: outputs These mechanisms focus management attention on achieving value chain economies

Organizing Vertical Integration Compensation Salary Integration Opportunism Cash Bonus: Individual Stock Grants: Individual Cooperation Leveraging Capabilities Cash Bonus: Group Stock Grants: Group Stock Options: Individual Exploiting Flexibility Time Horizon Stock Options: Group

Summary Vertical Integration… • makes sense when value chain economies can be created and captured • may allow a firm to leverage capabilities • may be a response to the threat of opportunism and uncertainty • as a form of exchange per se, is not rare nor costly to imitate

Summary Vertical Integration… • is an important consideration in the decision to expand internationally (range of possibilities) • makes sense when done for the right reasons, under the right circumstances • can be a costly mistake if done wrong Ownership is costly—integrate only when the benefits outweigh the costs of integration!

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